In order to start saving for their retirement, small business owners need to make a few tweaks in their business and personal lives, and be sure to set up a retirement plan that is aligned with their goals and business perspectives. Luckily, an abundance of retirement plans exclusive for small business owners provides them with a set of unique options, opportunities, and flexibility to save for their retirement that are not usually available to regular folks. However, in order to maximize these benefits and use them to their maximum advantage, small business owners should approach their retirement in the same way as they approach their business. Otherwise, negligence may cost them too much.
Below are common mistakes that can compromise your retirement. Make sure they do not apply to you.
1. Not Setting Up a Retirement Plan
Small business owners are very busy and usually responsible for many things. It is understandable that they do not have enough time to plan for their own future and retirement. However, it’s not an excuse for putting your own future at risk. By not having a retirement plan in place you are not only forgoing tax-free growth of your money, but also miss on business expenses deductions for every dollar you contribute.
No matter how busy you are, set up your retirement plan as soon as your business is profitable, self-sustained, and revenue stream is predictable. The earlier you start the more time you have to grow your investments and enjoy the power of compounding.
2. Choosing the Wrong Plan
There are a few plans small business owners can choose from to save for their retirement. Choosing the wrong one can make it time-consuming and costly to upgrade to another one. Before you decide on which plan to choose, make sure to decide on the annual amount you are going to contribute towards your retirement, possibility of hiring new employees, additional plan features you may want to use in the future, and whether plan fees and administrative simplicity are important to you. It may be wise to consult with a retirement plan specialist before setting up a plan as s/he can save you a lot of hassle.
3. Relying on Business as a Source of Retirement Income
Some people start their own business in order leave a legacy or a generational mark, some in pursuit to make the world better, others to grow and sell it at some point of time in the future. No matter what your true goals are, do not count on a business as a source to fund your retirement. Here are two important statistics:
- Failure rate of small business is high, only 45% surviving for first 5 years
- 80% of businesses listed for sale never sale
Real data is harsh. Where will your income come from if your business fails or couldn’t be sold? That is why it is extremely important for you to save for retirement and separate your business and personal finances. Even if you grow the business to a cash-generating machine (and I am sure you will), you are still better off tax-wise by setting up your retirement account and contributing towards your retirement savings.
4. Not Contributing Enough
Some retirement plans provide very generous contribution limits and you have to be sure that you are contributing up to this limits. If your plan provides for both employer and employee contributions, make sure to contribute your own, employee’s portion and match the rest with employer’s. The point is to contribute the maximum your plan allows in order to save on both business and personal taxes and grow money tax-free.
5. Taking a Loan for Business Purposes
Depending on the plan you have, it may or may not allow you to take a loan for business or other purposes (up to $50,000). While taking a loan from your own retirement account is probably the easiest and most hassle-free way to get cash for business development (or any other purpose), it is not always the best and right approach. First of all, you are forgoing investment income on the loan amount that may have accrued during the loan period. This lost investment income could be very hard to make up for. Secondly, you will have to pay taxes twice on the loan repayments, which are made with after-tax (not pre-tax like initially) money. When you withdraw money in retirement, those loan repayments will be taxed again. Consider other alternatives, such as obtaining a bank loan, especially with the low interest rates we see now. Do not commingle your business and retirement assets. Tap your retirement funds only in case of emergency.
6. Defaulting on a Loan
If you had no other options but to take a loan against your retirement plan, do not default on it. If you default on your loan you will not only lose that borrowed portion as a retirement income forever, but will also have to pay taxes on that amount as well as an additional 10% penalty (if below age 55). Remember, an unpaid loan is classified as a taxable distribution by the IRS.
7. Exceeding Contribution Limits
Small business owners often lose track of total contributions they make towards their retirement accounts. Again, it is understandable when you have to be responsible for many things going on with your business. However, despite all your busyness, I’m sure you never lose track of all eligible business expenses that you would like to deduct later on, right? You have to track your retirement contributions exactly the same way.
If you made an excess contribution to your retirement plan, you usually have time before your tax filing deadline to withdraw the excess amount. This excess contribution plus any earnings on it will be included in your taxable income. If you fail to withdraw the excess contribution, you will most likely be taxed twice: for the year you contributed and again when you withdraw the money.
8. Poor Investment Diversification
In addition to already handling numerous business things, many small business owners are willing to add one more – investing their retirement funds on their own. However, lacking knowledge and time, they usually end up with a portfolio that misses on a critical component of successful investing – diversification. For example, the portfolio can be either loaded up with individual stocks or consisted of a single asset class, like equities. Yes, you can win big with that type of allocation, but you can lose a lot, too. The right investment approach is to diversify your retirement funds among different asset classes, like stocks, bonds, and real estate. In other words to spread eggs across multiple baskets. You will most likely end up making less should the stock market skyrocket, but you will also avoid losing way too much when it plummets. Consult with you investment adviser in order to create the right asset allocation mix.
9. Investing Too Aggressively or Too Conservatively
Sound investment approach should be based on your goals, age, and risk tolerance. That means that your investment style and current asset allocation should match your personality. If you are young enough and have at least 30-35 years ahead, being aggressive may sound like a right approach, while in fact it is not. For example, if you invest too aggressively (read take too much risk) you may not be able to tolerate a market plunge and may end up capitulating at a bad time. The opposite is true for being too conservative. If your portfolio is composed of low-risk investments, like government bonds or money market funds and you have enough time to retirement, your money may not grow fast enough to keep up with inflation or produce meaningful returns. Make sure to start with an allocation that you are comfortable with and as a rule of thumb, adjust your asset allocation along the way. The closer you get to retirement, the more conservative your portfolio should become.
10. Ignoring Rebalancing
Rebalancing is a technique of bringing the weightings of asset classes in the portfolio back to their target weights. Let’s assume a traditional portfolio that has 60% invested in stocks and 40% in bonds. Over time, due to market fluctuations, the stock portion of your portfolio may grow to 80%, exposing you to a greater risk than you initially planned to. So what do you do? You need to bring the stock portion back to its original weight of 60% by selling stocks and buying bonds. Rebalancing is an ongoing process that should be done at least annually.
11. Ignoring Fees
As a small business owner, you can keep plan fees to some extent under control. Depending on the retirement plan you have in place, they can vary from very low to moderate. However, when it comes to investment fees associated with mutual or exchange-traded funds, many small business owners remain inattentive and usually pick up not very cost-friendly options. High fees have a direct and negative effect on the account value and can eat up a significant portion of you potential income. Moreover, they can delay your retirement goals by a few years. If you are not sure what funds to include in your portfolio, make sure to consult with your investment adviser first.
12. Not Naming a Beneficiary
No matter what retirement plan you have, you need to name your beneficiary in advance. In a 401(k) account, by default, federal law names your spouse as a primary beneficiary of your retirement account upon your death. However, if you want a child to inherit your account make sure to obtain a spousal waiver and name your child as a beneficiary in the beneficiary designation form. If you are single, it is extremely important to name your beneficiary. Otherwise, the money in the account will go to your estate and may end up in someone else’s other than your family member hands.